1. Field of the Invention
This invention relates to a method, a system, and a computer program product for trading and settling a product. More particularly, the present invention relates to a method, a system, and a computer program product for trading and settling a contract having a price based on any preselected interest rate swap curve.
2. Discussion of the Background
An interest rate swap (IRS) is a well known financial transaction which usually occurs between two parties. In a swap, the two parties agree to make payments to each other; the payments of the first and second parties define the type of swap. In a basis swap, the payments made by the first and second parties are based on different floating (i.e., changing) interest rates in the same currency. In a currency swap, the payments are made based on either fixed and/or floating interest rates in different currencies. In an IRS, the payments made by the parties are in the same currencies, but one of the party's payments are based on a fixed interest rate while the other party's payments are based on a floating interest rate. The two parties to the IRS are called counterparties.
The purpose of an IRS is often to insulate or protect (like buying an insurance policy) one of the parties from changing interest rates. However, such an insulation or protection from changing interest rates results in an added cost to the party seeking protection from the potential change. This type of financial transaction, where the risk of loss is reduced, is referred to as hedging. In the IRS, while one party is hedging its losses, the other party is seeking financial gain based on speculation that the added cost paid by the party seeking to hedge its losses due to interest rate fluctuation will be greater than the actual change in value due to the interest rate change.
Advancing to further details of the mechanics of an IRS, the payments made between the parties are based on interest rates. However, the interest rate is only one factor in determining the amount of payment; the other factor is the amount of principal which is periodically multiplied by the different interest rates to determine the payments made by the parties to each other. However, in an interest rate swap, there is no exchange or payment of principal, so the principal is referred to as being a notional amount. This notional amount dictates the size of the interest payments and is agreed on by the parties when negotiating the terms of the IRS. The notional amount remains constant for the duration of the swap. For those unfamiliar with financial terminology, a glossary of general financial terms is provided in the appended "Glossary of Terms."
FIG. 1 illustrates an exemplary IRS between a first dealer 2 (e.g., a typical bank which is relatively small in size) which desires to reduce the risk of interest rate fluctuation and a second dealer 8 (e.g., a large financial institution) which is willing to accept a risk in interest rate fluctuation in return for receiving a higher fixed interest rate. The first dealer 2 agrees to pay the second dealer 8 interest payments that are based on a long term fixed rate. In exchange, the second dealer 8 agrees to pay the first dealer 2 interest payments that are based on a short term floating rate. Thus, the first dealer 2 and the second dealer 8 are counterparties. Typically, the floating interest rate is tied to the London Interbank Offered Rate (LIBOR). If the first dealer 2 and the second dealer 8 enter into a swap over a period of five years, the first dealer 2 pays out interest to the second dealer 8 according to the fixed long term rate and receives interest from the second dealer 8 according to the three month LIBOR rate for a five year period. Conversely, the second dealer 8 receives interest payments from the first dealer 2 according to the fixed long term rate and pays interest payments to the first dealer 2 based on the floating short term rate (i.e., the three month LIBOR rate). As mentioned above, both the fixed long term rate and the LIBOR rate are applied to a common notional principal. Alternatively, both series of cash flows could be based on different floating interest rates, i.e., variable interest rates that are based upon different underlying indices. This type of IRS is known as a basis or a money market swap.
Before entering an IRS contract, the first dealer 2 and the second dealer 8 may try to value the price of the IRS before making a decision whether to enter into the IRS contract. The value of an IRS is the difference between the net present value (NPV) of the two future income streams that are swapped by the first dealer 2 and the second dealer 8. Because the floating interest rate varies in the future, the size of each future cash flow based on the floating interest rate is not known to either the first dealer 2 or the second dealer 8. To solve this problem the swap market uses forward implied interest rates to estimate the NPV of the fixed and floating interest rates. The forward interest rates may be derived from the International Swap Dealers Association (ISDA) Benchmark Swap Rates fixing for example.
An IRS is effectively a construction of two cash flow streams with the same maturity. One of the cash flow streams is comparable to that of a bond (fixed interest rate payments) and the other cash flow stream is comparable to a periodically revolving borrowing/lending facility or Floating Rate Note (floating interest rate payments). Mathematical analysis shows that the NPV of an IRS has an interest rate sensitivity similar to the price of a bond having a similar coupon, maturity, and credit rating.
The similarity in the interest rate sensitivity of IRSs and bonds explains the heavy use of government bond futures, government bond repos, and the cash market to manage interest rate risk resulting out of IRS transactions. However, this practice also involves two major disadvantages. First, both market segments are based on different credits and therefore an unexpected change in the yield differential of the two markets could result in heavy losses. Second, conventional techniques require efficient access to the bond and repo market. Specifically, repo transactions can be problematic since these transactions have to be renegotiated on a regular basis and market conditions can be very volatile.
For a more comprehensive treatment of the subject of swaps, see Kolb, Robert W., "Futures, Options, and Swaps," 2.sup.nd ed., May 1997, incorporated herein by reference. For an overview of general financial theory, see Brealy and Myers, "Principles of Corporate Finance," McGraw-Hill Companies, Inc., 1996, incorporated herein by reference.
The IRS market is, by some measures, the largest sector of the global fixed income market. The size of the IRS market has grown from zero dollars in 1980 to approximately $30 trillion outstanding as of mid-1998.
Despite the enormous size of the IRS market, barriers to entry exist for new, and sometimes existing, participants. This is due to the fact that the IRS market is a marketplace which is based on bilateral agreements rather than on tradeable and securitized assets. However, the International Swaps and Derivatives Association (ISDA) provides a legal master documentation for IRS transactions (http://www.isda.org/cl.html), which is heavily used. ISDA agreements are essential for each new counterparty, and amendments to agreements are required for each new deal with a particular counterparty. Thus, each transaction is a separately negotiated contract with little standardization of financial terms. The contracts are lengthy and complex, and legal review is required for each transaction. Hence any large and sophisticated users must endure the overhead burdens associated with the conventional, inefficient operating environment of the IRS market.
Within the IRS market, bilateral netting agreements facilitate netting of positions between specific counterparties by reducing credit exposure and freeing up capital; however, it is difficult, if not impossible, for participants to freely net deals across multiple counterparties. Further, it is time consuming and cumbersome to settle each agreement separately, and there is no guarantee that the cancellation or assignment of a particular contract provides the best price.
The users of the IRS market are, in essence, all organizations who are exposed to interest rate risk. This includes banks, state treasuries, supranational organizations, insurance companies, investment funds, large corporations, and increasingly small and medium sized corporations. The major participants and liquidity providers in the IRS market are global banks which are able to manage interest rate risk and efficiently administer the vast number of IRS transactions.
The various barriers to entry into the IRS market have resulted in a heavy concentration of business among a handful of the largest global banks. This oligopolistic environment has led to an artificial lack of market transparency (since each transaction is unique and propriety to the counterparties) and the discrimination of many market participants who would benefit from more direct access to the IRS market. Large and sophisticated users of IRSs (for example, large corporations) must often operate at a pricing disadvantage to the large global banks with whom they must conduct their business.
In the past, at least one attempt was made to eradicate some of the problems that exist in the IRS market. In the 1980's, the Chicago Board of Trade (CBOT) introduced a product that sought to replicate the interest rate sensitivity of an IRS by applying the product design of short-term interest rate instruments, i.e., 100 minus the IRS rate of a predefined maturity. However, the CBOT product exhibited considerable design problems and received little customer support.